Mortgage Meltdown?

A funny thing happened last week. Mortgage rates remained basically unchanged, inching up just 2 basis points to 5.81% from 5.79% a week earlier, according to the Mortgage Bankers Association of America. But demand for refinance loans and purchase loans dropped. Like a rock.

This was not your garden-variety drop. It was a huge plunge: Applications for refi loans sank more than 22%. Applications for purchase loans crashed 19%.

Refinance applications are now down MORE THAN 75% from their late-May peak while purchase applications are at their lowest level since April.

* The big reason consumers were rushing to refinance their mortgages until May of this year was FALLING mortgage rates. Whenever rates fell another notch, it generated a new crop of mortgage refinancing. But when rates STOPPED falling, the new demand began to dry up. And now, although mortgage rates did not rise very much in the most recent week, they are still up 75 basis points (three quarters of a percent) from the multi-decade lows set in the spring. That's killing the mortgage refi boom.

* When mortgage rates were falling, new home buyers could thumb their noses at rising home prices. "So what if the house is more expensive?" they said. "As long as our monthly payments are lower, who cares?" Now, though, the price increases of the past five years are finally going to cause sticker shock. Indeed, during that period, personal income rose 23% while the average price of a new home jumped 27% and the average price of an existing home skyrocketed 39%.

Combine the two factors -- higher mortgage rates AND higher home prices -- and the result is a significant jump in monthly payments. That means big trouble for the housing market.

Remember: The mortgage boom is what powered demand to the frothy bubble level where it still rests today. Now, what will happen as the mortgage boom comes to an abrupt end? What will be the impact on the rest of the economy?

* A huge source of new cash into the economy -- for spending or even stock market investing -- dries up ...

* Real estate, mortgage and construction industries -- among the few that were ramping up their hiring -- start shedding workers ...

* The real estate industry drops many of the 64,000 jobs it has added since May 2000 ... the construction industry drops many of its 70,000 ... and the credit intermediation industry (which includes mortgage lenders) drops a big portion of the nearly 250,000 jobs added since 2000.

* All industries that feed off of a booming housing market -- furniture, carpeting, home appliances and more -- fade quickly.

* The entire consumer economy sinks, setting off a chain reaction of declines in virtually every industry.

This won't happen tomorrow. But as long as mortgage rates continue moving up, it's hard to imagine how it can be avoided in the months ahead. And whether this scenario starts unfolding now or next year, it's certainly not too early to take protective action: Reduce your debt. Avoid sinking more money into investment real estate. Build liquid cash, regardless of how low the current yield may be.

It also correctly, in my view, points to a fundamental moral lassitude as the basis for economic decline.

Arete, Starwind, TauZero and I are always being accused of being either perma-bears, or anti-Bush. That's just not the case.

I'm a libertarian, but I voted for Bush last election, and expect to do so again in 2004. Because of the way our election system works, there are really only two choices, the Democrat or the Republican. Failure to understand that just risks giving the victory to the socialist enemy.

And the fundamental moral lassitude that plagues us is a disease that infects our society as a whole. It is not the fault of the politicians. Most of them are followers, not leaders. The ones who can actually lead people to new opinions, new policies and new allegiances are few and far between. Reagan had it. FDR had it (unfortunately.) The Founders had more of it than any American leaders since that time.

As for being a perma-bear, all I can say is that I believe in dealing with things as they are, instead of the way I wish they were. The Federal Reserve isn't holding interest rates at historic lows, well below the market rate, just for fun. The take home message of the past two years isn't the tepid signs of possible economic improvement, it's how tepid the signs are given the tax cuts and Federal Reserve policies that have been wielded to jump start the economy. When you step on the accelerator, and the car barely goes any faster, something's wrong, and no mistake.

As for our discusion on interest rates, I suspect there have been some misunderstandings. Unfortunately, there's something about online interaction that brings out an aggressive, combative and competitive attitude. I don't like to interact with people that way, nor do I have the time to exhaustively debate every nuance and corollary of some issue, just for the satisfaction of having the last word.

If you'd like to be added to my economy/market ping-list, let me know.

All of my commentary as to the fundamental determinants of market interest rates have been made in the context of the Fed supplying liquidity in balanced fashion as required by the domestic economy, as they have done for decades. Interest rates are, nonetheless, a market price for money and will always reflect supply and demand forces. Should foreign central bank holders of massive U.S. Dollar reserves tire of funding our balance of payments deficits or, worse, decide to reduce their holdings, the U.S. would be faced with a massive oversupply of Dollars which would basically require that the Treasury and the Fed raise interest rates simply to induce holders to continue to hold. That would be only a temporary "fix" however. Ultimately we must right our balance of payments deficit and that would be anything but easy to do in the short run. Severe domestic economic pain would result, I believe.

[Your "fundamental point" now is not consistent with your earlier posts.]

Well, now, I beg to differ. Perhaps you should again read my earlier posts

I read them and copied your earlier points verbatum into my post #90 and summarized them (which summary I didn't see you dispute) and copied your "fundamental point" into my post #96 and laid out the comparison of the two. Perhaps if this is a semantics issue, you could be more specific as to what you meant or which words in post #96 I've not properly compared?

Come on, Starwind, you are talking about the yield curve and validly correlating inflation to market interest rates requires matching maturities.

I was not correlating any specific maturities to the graph or interest rates. The juxtaposition of my description of 'duration premium' at the end of post #96 was simply coincidental (it had to go somewhere - perhaps a topic-change note was needed) and not related to the previous point refuting your specific assertions as to what was an 'in-line real rate of return variation around a mean over time' - a discrepancy between your post #91 and the graph you haven't yet addressed.

Are you suggesting the yield curve would be flat if there were (hypothetically) exactly zero inflation and zero risk of inflation over 30 years?

I simply asserted that investors expect and receive a premium for allocating their principal over a longer period of time.

Further, If I were one of your substantial customers and negotiated a $5M zero coupon bond for say, 2 years, at whatever your requested rate, plus I guaranteed you an inflation compensation premium adjusted, say monthly (so you had no risk of inflation loss), then upon agreement to those terms if I said, "Great, now lets just extend the term out 30 years" - you would agree? With no additional premiums charged? You would not charge more for my keeping your principal an additional 28 years?

What other fundamental determining factors are there?

The following are each determined independently and arise for different reasons, inherent to the nature of the loan:

Real risk-free rate
The rate of interest excluding the effect of expected inflation and compensates the investor for the temporary sacrifice of consumption.
Inflation premium
Compensates the investor for inflation and the risk of estimating inlfation wrong.
Duration Premium
Compensates the investor for lost opportunity over time of alternative investments.
Default risk premium
Compensates the investor for risk of the loan not being repaid or repaid on schedule
Liquidity Risk Premium
Compensates the investor for risk of illiquid collateral assets upon repossesion
Price risk premium
Compensates the investor for risk of having to sell originated loans at a discount
Call risk premium
Compensates the investor for risk of cash flow uncertainty and reinvestment risk introduced by a call provision
Structural Risk premium
Compensates the investor for risk associated with differing cash flows driven by movements in interest rates in different ways as new and different types of fixed income securities can encompass anything with an anticipated and measurable cash flow are candidate to be securitized.
An extreme example is the musician David Bowie who securitized his expected royalty payments on his first 25 albums over the next 10 years and received $55 million from investors.

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